Alternatives to the simplified methods
There are several rules in the 2018 regulations that prohibit certain costs from being capitalized using one of the simplified methods (e.g., uncapitalized direct costs or variances). Instead, taxpayers are generally required to adjust their financial statement inventory for any costs under one of these rules. Because the IRS position is that such costs must be allocated to and among individual items of inventory rather than capitalized as lump sums, taxpayers likely have had and will continue to have substantial burden to comply. For example, the 2018 regulations provide de minimis safe harbors that generally allow taxpayers using the SRM, SPM or MSPM to allocate certain uncapitalized direct material costs, direct labor costs, and variances using the simplified methods to the extent the relevant cost does not exceed a 5% limit.7
Commonly, taxpayers exceed one or more of these safe harbors and are required to adjust their financial statement inventory as a result. For instance, companies with substantial amounts of trade discounts (e.g., large retailers) that do not take them into account in ending inventory for financial statements may exceed the de minimis rule for uncapitalized direct materials. It is also common for many taxpayers to exceed the safe harbor for variances that are not included in ending inventory for financial statements.
Additionally, the amount of the costs capitalized to inventory must be the tax amount. Taxpayers without applicable financial statements8 are not eligible to account for book/tax differences related to costs capitalized in their financial statement inventory through the simplified methods. Instead, such taxpayers are required to adjust their financial statement inventory for relevant book/tax differences prior to computing capitalization under one of the simplified methods.
Accordingly, taxpayers with facts that require separate complex calculations to implement one of the simplified methods may want to investigate other non-simplified methods that could prove more cost beneficial.
One alternative that frequently results in less cost capitalization for taxpayers is the use of a burden rate method. Under this method, the taxpayer develops predetermined rates for capitalizing additional costs and book/tax differences at various points of the inventory life cycle, such as the stages of the supply chain.
For example, resellers with large distribution hubs that use the burden rate method might establish separate burden rates (purchase, receive, move to storage, pick and pack for delivery to store) that better align the costs incurred at each stage with the units of inventory at each stage, often resulting in less UNICAP costs capitalized to ending inventory. Generally, for the burden rate method to be cost-beneficial, taxpayers must be able to generate the information necessary to develop the burden rates, which includes both:
- Cost-level information for each stage
- Inventory reports for each stage that depict inventory in a consistent unit of measure (e.g., pairs of shoes)
The burden rate method provides more flexibility than the simplified methods, and taxpayers with significant amounts of inventory that invest the time to establish a more elaborate burden rate method can often significantly reduce their cost capitalization.
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